Despite cryptocurrency rapidly gaining global recognition as an asset class worth having, there is still much for novice investors to learn. For one, understanding the varying types of decentralized assets can be overwhelming, especially for those new to the concept. Naturally, when more complex topics, such as the idea of crypto taxation, arise, it can be a bit difficult to grasp. To help give newer traders an idea of how crypto taxes work, let’s break down some core principles.
The IRS Stance: Crypto As Property
To better understand how crypto taxes work, it is essential to know how taxes work in general. The first thing to know is that there are various types of taxes aside from income taxes, with one important class being property taxes. For this form of taxation, the government (or the governing authority within the specific jurisdiction) deducts an amount based on the value of property owned or the property type and how its value fluctuates.
You may wonder how this relates to crypto taxes. The answer is directly since the IRS considers cryptocurrency ‘property’ instead of a literal currency when it comes to taxation categories. This allows it to be taxed as an asset class that, in some cases, follows the tax rules related to capital gains and losses. This means that where such rules apply, the government can tax you on how much the value of your crypto assets rises during a given tax period.
While these values can also go down, this generally means that taxpayers can simply offset the loss against the taxation owed on future capital gains. Given the rising popularity of cryptocurrencies these days, there is now no end of novice traders on the lookout for the best crypto projects to watch. Rather than investing in obvious choices like Bitcoin and Ethereum, keen investors are looking for new projects that offer potentially lucrative returns.
For these eager traders, learning to traverse the complexities of whitepapers and other indicators can help new investors find new tokens that can be very lucrative. With the potential for enormous short-term gains in some cases, crypto trading is now a massive draw. However, for those who aren’t aware of the taxation status of crypto assets, it’s highly recommended that amateur traders take the time to learn about these aspects before investing large sums.
Identifying Taxable Crypto Transactions
In its simplest form, any crypto-related activity that results in the owner gaining or losing monetary value in relation to the asset triggers what can be considered a ‘taxable event’. A great example is selling crypto for cash or converting it back into traditional currency (e.g., EUR, USD, etc.), which is the most straightforward event type.
However, crypto-to-crypto trades are a bit more complex, as they trigger the disposition of the first asset, thus resulting in a taxable event. Finally, spending your crypto tokens also counts as a taxable event, as it entails selling the currency for its market value at the time of said transaction. In simple terms, this means the tax man is now owed his share and will certainly come calling for it at some point.
To dive deeper into the complexity of taxable events, let’s start by looking at how crypto is taxed when received as income. If it is received as mining or staking rewards, the former is taxed as normal income, whereas the latter is taxed the same, but only once the taxpayer gains control of the reward. The same can be said for crypto airdrops, alongside receiving crypto as a payment for any goods delivered or services rendered.
In comparison, DeFi activities see lending and borrowing itself not as taxable events, but rather, the interest earned or liquidated collateral. If you receive rewards from liquidity or earn capital gains and royalties from selling NFTs, these are usually taxed as income.
Non-Taxable Crypto Activities
While taxable crypto-related activities are easy to understand after exploring their nuanced nature, what classifies them as non-taxable crypto activities? For one, buying and holding a cryptocurrency would not count as a taxable event, as no disposition occurs. Additionally, if you want to move your tokens between your personal wallets, this would not be levied as tax. Let’s say you are transferring your assets from an exchange to a personal hardware wallet that you own, granted that you provide proof of ownership, this will not incur taxes.
If you are in the giving mood, then you will be happy to know that gifting crypto is another non-taxable event. However, there is an annual gift tax exclusion that varies per year, and if this amount is exceeded, the giver may need to file a gift tax return. Lastly, while there is room for charity donations to be taxed, it would vastly depend on the surrounding circumstances. Usually, if the currency is donated directly to the organization, no capital tax gains would be owed.
Calculating Gains and Losses: The Essentials
To further understand crypto taxes, breaking down how gains and losses are calculated can provide better clarification. First, there needs to be a cost basis that stands as a crypto asset’s original value (including any associated fees and its purchase price), as this is vital for the calculation to occur. Next, at the time of a taxable event, each crypto transaction must be converted to its FMV (fair market value) in its corresponding FIAT currency. From here, the amounts will either be taxed at a short-term rate (ordinary income rates) or a long-term rate (favorable longer-term capital gains).
As with traditional currency taxation, crypto taxes can also see capital losses offset capital gains (which can even impact ordinary income). An array of accounting methods is used to calculate this form of tax, ranging from the number of crypto units sold to the impact of gains and losses. Some of these inventory accounting methods include LIFO and Specific Identification, with FIFO (First-In, First-Out) often standing as the default option in most jurisdictions.
Advanced Scenarios and Nuances
While crypto taxation is easy to grasp once you are informed on how it works, there are still some complex situations that call for a more nuanced understanding. As mentioned, hard forks and airdrops are usually taxable as regular income, whereas with wrapped tokens, there is much debate on whether they would be taxable or non-taxable. The main argument is whether these could be considered a technical step or a swap. Surprisingly, gas fees and other transaction costs can also impact the cost basis of a taxable event to the extent that expenses are deducted based on the amount.
Wash fees are also a concept that mainly applies to traditional securities in the US, but can be used to cryptocurrencies going forward. In essence, this entails that even if an asset is sold and repurchased quickly, it could still be realised as a loss where taxation is concerned.
Of course, while this might not be applicable at the moment, it could significantly impact taxable events for digital assets going forward. Lastly, it is important to keep in mind that while the IRS establishes taxation regulations in the US, these laws differ from country to country. As a result, checking your local laws is important when considering how your currencies will be taxed.